Multiple Reference Points and the Demand for Principal-Protected Life Annuities: An Experimental Analysis

Abstract

In this paper we analyze if multiple reference point theories can explain the relatively high attractiveness of annuities containing a capital guarantee. Therefore, we conducted a laboratory experiment where participants were confronted with an experimental annuitization decision from a mental accounting perspective. Previous research has shown that combining mental accounting and prospect theory can explain why annuities containing a guarantee are preferred to standard annuities, but this approach suffers from the shortcoming that from this perspective people would not annuitize their assets at all, but rather invest the money in a risk-free alternative. Recent research has extended prospect theory by additional reference points, in particular goals and thereby found a "cushion effect". When all possible outcomes of two options are above a certain goal, this goal serves as a cushion against negative emotions like disappointment and regret. Hence, individuals have a higher propensity to choose the risky option over the risk-free alternative with the same expected value. In our experiment, we find that individuals are more willing to purchase an annuity if it contains a capital guarantee. Moreover, we find evidence that individuals using this guarantee as a cushion were even more willing to choose the annuity. Hence, the "cushion effect" can partially explain the high demand for capital guarantee features in annuity contracts.2

Multi Cumulative Prospect Theory and the Demand for Cliquet‐Style Guarantees

“…Moreover, studies suggest that investors can simultaneously consider multiple reference points without combining them (cf., e.g., Ordóñez, Connolly, and Coughlan, 2000). Knoller (2016) shows that adding a goal that serves as cushion can partially explain the high demand for guarantees in annuity products.…”

What Do We Know About Annuitization Decisions?

“…In addition, the product design plays a crucial role in the attractiveness of annuities. For example, Hu and Scott (2007) show that "longevity annuities," with a lifelong payout starting in the future, are preferred over immediate annuities (see also Milevsky and Young, 2007a;Scott, 2011), which the authors attribute to an overweighting of the small probabilities of a long life expectancy and that lifelong products with period-certain guarantees are preferred over ones without this feature (see also Brown, 2003;Knoller, 2016). Moreover, Gong and Webb (2010) find that real annuities 18 can have higher or lower money's worth ratios (MWRs) than nominal ones, while Peijnenburg et al (2016) observe higher or lower annuitization rates for these products depending on the choice of model parameters.…”

Individual Capability and Effort in Retirement Benefit Choice

“…However, we use the label "risk insensitive" here rather than "irrationality" because we cannot show a general proof of this result for any concave and increasing utility function. 20 See Knoller (2016) for a discussion of preferences for guarantees in annuity decisions. Note: This table shows the proportions of response sequences that were risk insensitive, based on simple counts.…”